Roman poet Ovid advised: “Keep a mid course between two extremes” and Steve Webb, the UK’s pensions minister, seems to agree. But in his attempt to achieve a mid course in the UK workplace pension systems, Webb has practitioners jumping though yet another hoop.

McLean: odd time to moot defined ambition

In July, he set the industry a challenge to find a solution that strikes a balance between the increasingly polarised defined-benefit and defined-contribution pension schemes.

Defined benefits guarantee pensioners a pre-determined proportion of their salary for life but leave the company exposed to potentially unlimited liabilities, while members of defined contributions depend entirely on investment returns and annuity rates prevailing at retirement, but employers are protected against spiralling deficits.

Darren Philp, director of policy at the National Association of Pension Funds, said: “There has been a fundamental shift of the risks for pensions outcomes from the employer to the employee.”

Webb wants to strive for a middle way between these two with a defined-ambition scheme – drawing inspiration from proposals in the Netherlands – that would see employers and staff share the risks.

In fact, he wants to create a spectrum of pensions risk sharing. His summer challenge, for example, sees defined ambition stretching solidly into the defined-contributions market. He specifically talked about developing money-safe guarantees under which members would be guaranteed that the nominal value of their contributions would not be lost. Anything more, however, would still depend on investment returns.

Webb has also praised the cash balance scheme of supermarket chain Morrisons under which the sum of the pensions savings pot a worker achieves at retirement is guaranteed, with the company responsible for making up any shortfall. However, the member is left to buy an annuity to turn that savings pot into an income, protecting the company from rising life expectancies.

Mark Pemberthy, director of employee benefits solutions at JLT, which advises the supermarket group, said: “Morrisons take the pre-retirement investment risk but the member still takes the post-retirement risk. They see it as a genuine risk-sharing arrangement.”

Such schemes are not without disadvantages, however. For one, as soon as companies offer any guarantee, they face having to comply with all regulation related to traditional defined-benefit schemes.
Stuart Southall, co-founder of actuary Punter Southall, said: “With a cash balance scheme you take some of the risk out around longevity but you’re still getting stuck with a scheme funding ratio and a Pension Protection Fund levy. It is all that paraphernalia that comes with it.”

Furthermore, time may be running out. Webb – who said the Department for Work and Pensions would release its detailed thinking later this year – has delivered his request just as pension providers and large corporations are embarking on the government’s five-year policy of auto-enrolment.

-- Odd time

Malcolm McLean, consultant at independent actuary Barnett Waddingham, said: “It seems a bit odd to be coming up with defined ambition at the very point when we’re automatically enrolling millions of people into bog standard defined-contribution schemes.”

Once companies have signed up their workers, he said, it is unlikely many will opt for another upheaval in a year or two.

And while the attractions of Webb’s proposals are clear enough, it is not a new idea. The Association of Consulting Actuaries has been arguing for reforms to encourage the development of a middle way for a decade. ACA chairman Andrew Vaughan says the change could be as important as auto-enrolment or government plans to increase the state pension: “Defined ambition gives employers the opportunity to offer better pensions and more certainty for workers, while still controlling costs.”

For private sector workers, it could mean they continue to enjoy benefits in retirement much closer to those of the public sector. For employers, they offer a degree of protection from the spiralling liabilities that have seen the widespread closure of final-salary schemes.

At the extreme, these liabilities can bankrupt companies. Directors of textile group Dawson International recently decided to place the company into administration after its pension’s deficit hit £129m.

“A defined-ambition plan couldn’t do that,” according to Thurstan Robinson at the Dutch headquarters of international pension provider Aegon Global Pensions.

Under Dutch proposals, employers’ contributions to the pension would be capped at their current levels, which, on average, are about 17% of salary. If this proves insufficient in providing the pension sum a member expects, they either receive less, must contribute more or work for longer. Robinson said: “It provides a safety valve.”

But the plan has yet to be fully tested. Even in the Netherlands, the proposals, agreed in 2010, have yet to be enacted.

Finding the balance between certainty for members and risk limitation for employers is challenging. Longevity, investment returns, inflation, interest rates and regulations all impact on the costs. Put limits on too many of these and scheme members gain nothing in the way of certainty. Too few and the company remains exposed to potentially spiralling liabilities.

Ros Altmann, pensions expert and director general of Saga, said: “There are lots of moving parts.”
Even a guarantee that contributions won’t be lost can come at a price. As Jamie Jenkins, head of workplace strategy at Standard Life points out, greater certainty usually puts limits on the potential growth which, given the low levels of contributions into defined-contribution schemes at the moment, members can ill afford to forgo.

He said: “You could invest in something that is underpinned but you need to factor in that there are costs associated with that guarantee. You can’t just assume there is no downside.”

-- Striking a balance

Most seriously for the new proposals, however, there is little evidence that businesses are crying out for another type of pension scheme.

Hybrid pension schemes and other risk-sharing arrangements already exist but industry sources say they are just not very popular. The majority of employers that have abandoned final-salary schemes have simply opted for a defined-contribution replacement.

According to the Pensions Regulator, of the total 32,082 private sector pension schemes open to new members at the end of March this year, 31,036 were defined contribution schemes (most with very little money), 914 were defined-benefit schemes, and just 132 were hybrids.

Tom McPhail, head of pensions at Hargreaves Lansdown, says the government should focus on making direct contributions work better by pushing for higher contribution rates, rather than creating new types of scheme: “Webb is fighting the wrong battle. Employers have generally already rejected the option of any form of defined benefit.”

Even Stuart Southall, former chairman of the ACA, who spent years arguing for a middle way, said: “I fear the horse has bolted.”

However, longer-term employers might yet come round. Paul Macro, head of UK defined contributions at consultants Mercer, believes interest in alternatives could increase, but it will have to wait for the weaknesses of defined contribution schemes to become fully apparent.

He said: “It is difficult to see many finance directors at the moment setting up another pension scheme when, as a new generation comes through in a few years, HR directors might then be putting on pressure to provide better benefits.”

-- Place your bets : Alternatives to DB and DC

Hybrids offer a mixture of defined benefit and defined-contribution elements. They might provide a guaranteed pension based on salary but capped at earnings of £30,000, for example, with higher earners receiving a top-up based on the performance of the markets. Others offer nursery schemes, where younger earners are enrolled in a DC scheme before graduating to DB.

Cash balance schemes offer what some see as a genuine risk-sharing arrangement. The employer guarantees the pensions pot a worker achieves at retirement with the company taking responsibility for making up any shortfall. The member is left to buy an annuity to turn that savings pot into an income, protecting the company from rising life expectancies.

-- Pros and cons

Hybrid problems are twofold. They tend to be more complex, which can lead to communication problems with members and running the scheme effectively. Last October, a pensions regulator report found poor governance in such schemes, with trustees not always understanding their structure or the benefits offered. They also leave companies exposed to the usual liabilities of DB schemes and the regulatory burden.

A cash-balance scheme, for example removes some longevity risk, but a scheme funding ratio between employers and members and the Pension Protection Fund levy remains a cost burden. These schemes could become more popular given a lighter regulatory touch.